Stock markets around the world fell sharply this morning, before recovering by the end of the day, on fears that an unprecedented levy on savers' bank deposits in Cyprus will plunge Europe back into crisis.

The FTSE 100 index, which has been trading at a five-year high above 6,500 in recent days, slumped 100 points or 1.5 per cent on the open, with banks among the biggest fallers. But the blue chip index later recovered to close down 31 points at 6457 - 0.5 per cent.

That recovery was in part a response to the news the Cypriot government would attempt to renegotiate the original terms of the bailout deal with the so-called troika of European Union (EU), International Monetary fund (IMF) and European Central Bank (ECB).

Angry Cypriots are asking why they are the first bailout (out of the five thus far) in which depositors have been scalped

Traders worried the precedent set by
the Cypriot bank rescue deal could spark an exodus of capital from other
fragile European economies, particularly Italy and Spain, and
jeopardise Europe's recent tentative economic recovery.

Unlike previous rescues for Greece,
Portugal, Ireland, and Spanish banks, the proposed Cypriot bailout is
the first one that dips into people's savings to finance a bailout.

Under the original terms of the bailout deal savers will be charged a one-time tax of 6.75 per
cent on all bank deposits under €100,000 (£86,490) and 9.9 per cent over
that amount in exchange for €10billion
(£8.6billion).

But by mid-morning the Cypriot parliament had announced the vote to approve the terms would be postponed until Tuesday afternoon to give Cypriot president Nicos Anastasiades time to barter a better deal.

The government is now working to soften the blow to smaller savers by tilting more of the levy towards those with deposits greater than €100,000 . One option being considered is the introduction of a tax-free threshold for smaller bank deposits of up to €20,000 which was understood to be under discussion but not yet agreed.

ECB Governing Council member Ewald Nowotny called for a quick and responsible solution in negotiations on a bailout package for Cyprus so as to avoid further turmoil.

Nowotny stressed that Cyprus was a 'special case' and that the country itself would be responsible for deciding how to come up with €5.8billion on top of the €10billion in bailout money that was agreed by euro zone leaders.

'Hopefully, a responsible solution will be reached quickly so that the special case of Cyprus (which accounts only for 0.2 per cent of the EU gross domestic product) will not lead to further concern,' Nowotny said.

On Monday morning the euro fell against sterling with the pound trading 1.07 per cent higher at €1.168.

Stock markets across Europe also fell as soon as they opened. France’s CAC40 fell1.69 per cent at 3,779.24, while
Germany’s DAX also dropped1.17 per cent at 7,948.50. The IBEX share index
in Spain - twice the subject of a European bailout of its banking system
last year – lost 2.12 per cent at 8,436.40.

The turmoil in Europe came after sharp drops in Asia, where Japan's Nikkei last night fell more than 2.5 per cent.

Michael Hewson, senior analyst at CMC
Markets, said: 'If European policymakers were looking for a way to
undermine the public trust that underpins the foundation of any banking
system they could not have done a better job.

'Not only is it in complete
contravention of the deposit insurance rules agreed by all EU countries
in October 2008, and an absolute PR disaster, but it opens up a
Pandora's box of all possibilities with respect to precedent and future
measures in other EU countries that find themselves having to ask for
help in the future.'

Last night, George Osborne said the Treasury will help out 3,000 British military personnel based in the country as well as civil servants who lose out as a result of the one-off tax. The bill to taxpayers could run into hundreds of thousands of pounds.

'Anyone doing their duty for our country in Cyprus will be protected from this bank tax,' Mr Osborne said.

Britain's Chancellor of the Exchequer George Osborne said the UK Treasury will reimburse military and government personnel with money in Cypriot banks

But up to 60,000 Briton's with up to £1.7billion saved in Cypriot banks still stand to lose out under the bailout. Many are expats and holiday homeowners.

Over the weekend Cypriot banks banned online transfers and emptied cashpoints to stop withdrawals provoking uproar among furious residents who attempted to smash into banks in one incident using a JCB.

In response to cries of outrage, Cypriot president Nicos Anastasiades, who was elected last month after saying he would never agree to such bailout terms, was last night trying to amend the tax to limit the pain for small depositors.

But Angela Merkel insisted it was right that all depositors in Cypriot banks should share the responsibility of bailing out the state.

Addressing an election rally, the German chancellor insisted: 'Anyone having their money in Cypriot banks must contribute in the Cypriot bailout. That way those responsible will contribute in it, not only the taxpayers of other countries, and that is what's right.'

The levy could be automatically taken from accounts as early as Wednesday.

Fiona Mullen, a British economist living on Cyprus, said: 'We knew there was a possibility they would take the deposits above the insured threshold – so above 100,000 euros – but nobody thought they would take it down to someone with five euros in the bank.

'I was trying to take money out of the ATM but I couldn't.'

David Symonds, another expat, predicted violence when banks reopened: 'Tempers could get frayed. Those frayed tempers could well lead to violence.'

Cypriot President Nicos Anastasiades is trying to rally support, but if he can't the country may crash out of the single currency

The Cypriot parliament postponed a vote approving the deal and was reported to have announced a further bank holiday on Tuesday – and possibly another on Wednesday – to keep banks closed.

Mr Osborne said that because David Cameron had extracted Britain from an EU fund agreed by Labour, British taxpayers would be spared a huge bill.

The Chancellor said Cyprus was an example of what would happen to Britain if it did not repay its debts adding that the government's spending cuts had maintained the confidence of global markets in the British economy.

'And unless we in Britain front up to our own problems – the problems in our banking system, the problems that we're borrowing so much money, the problems that actually our businesses need more help to create jobs - if we don't do those things then the difficult economic situation in Britain will get very much worse,' Mr Osborne added.

UKIP leader Nigel Farage said British taxpayers were being asked to pay for a 'disgraceful euro-larceny'. 'Outrage is a word overused in political debate, but hardly covers this,' he added.

Economists at Barclays said the proposed tax on deposits is an 'ominous' sign.

'The imposition of a levy on depositors in Cyprus is a material development that furthers the erosion of bondholder protection at European banks,' Barclays experts Laurent Fransolet and Antonio Garcia Pascual said in a report.

Stock markets have risen strongly in recent weeks, partly because the worst of the eurozone crisis appeared to be over – though critics have warned this was illusory.

British-based offshoots of Cypriot banks, the Bank of Cyprus UK and Laiki Bank UK, said their customers here are unaffected.

Barclays has a small presence in Cyprus and a spokesman said it is not yet clear whether its depositors on the island will be subjected to the savings snatch.

'This will probably go down as an ill-thought-out rescue plan with consequences for peripheral Europe,' said Sebastien Galy of Societe Generale.